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Japanese pension fund executives appear poised to tweak their bond allocations for the coming year more than their equity targets, even as promises of aggressive stimulus policies by the incoming prime minister, Shinzo Abe, have fueled explosive gains for Tokyo stocks.

Market watchers say after more than two decades of economic pain for Japan, local pension executives are just as likely to use the 20% gain Tokyo's benchmark Nikkei index has enjoyed since mid-November as an opportunity to take profits as to rethink long-standing moves to lower allocations to domestic equities.

After 15 years of zero interest rates and numerous false starts for local stocks, investors are “very, very skeptical and very conservative,” noted Alex Sato, Tokyo-based CEO of
Invesco (IVZ) Japan.

Japanese pension overseers have adapted to that long stretch in ways that effectively work against a renewed focus on domestic equities anytime soon, market veterans say. For example, in recent years, pension executives cut annualized investment return targets to between 2% and 3%, leaving them less reliant on riskier options such as Japanese equities to achieve their goals, noted Tadaaki Komatsubara, chief investment officer in Tokyo for Ibbotson Associates Japan Inc.

Whether Japan's latest election could prove a turning point in the country's stubborn economic malaise is the question. The convincing victory for Mr. Abe's Liberal Democratic Party in the Dec. 16 general election was grounded on the conservative party leader's pledge to revive Japan's long-dormant economy with heavy doses of infrastructure spending and enough monetary stimulus to replace persistent deflationary pressures with modest inflation.

Wait and see

Market veterans say enough questions remain about Mr. Abe's ability to deliver on his pledges to justify a wait-and-see stance. Even so, any success could call into question asset allocation shifts by local pension executives over the past 10 years, which sharply reduced holdings of domestic equities while boosting already hefty weightings in Japanese government bonds with annual yields of less than 1%.

According to data compiled by Towers Watson K.K., the Tokyo-based subsidiary of investment consulting giant
Towers Watson & Co., between Dec. 31, 2000, and Dec. 31, 2010, Japanese pension funds' average allocation to local bonds rose to 41.9% from 31.5% while allocations to domestic equities plunged to 16.2% from 34.7%.

More recent data compiled by Japan's Pension Fund Association show a similar trend for domestic equities, with an average allocation plunging to 17.4% as of Dec. 31, 2011, from 34% as of Dec. 31, 2000. The PFA data, which break out insurance “general account” products as a separate category, show those general account allocations rising to 14% from 11.3%, and domestic bond allocations climbing to 27.2% from 21.3% over the same period.

For the most part, market veterans don't expect a dramatic rebound in domestic equity allocations. According to Mr. Sato and others, the bulk of the buying fueling the recent upswing by Tokyo stocks has come from overseas.

There are exceptions. Some pension executives who sharply reduced their local equity allocations in the past said they've either added more domestic shares in recent months or are reviewing their weightings now in light of the latest economic policy discussions.

Yoshihiko Sato, Tokyo-based fund manager of the 46 billion yen ($529 million) pension fund for information technology systems provider NEC Fielding Ltd., which has a weighting of less than 1% in Japanese equities, said his team is considering adding to its holdings of domestic shares now — as it evaluates whether the new government's policies will result in lower equity-related risks and increased risks relating to government bonds.

Yoshisuke Kiguchi, chief investment officer of the 40 billion yen Okayama Metal & Machinery Pension Fund, Okayama, meanwhile, said after underweighting Japanese equities for the past three years, his team — anticipating “the slow normalization of the Japanese economy” and seeing local shares as oversold — brought its weighting to a neutral 8% of the portfolio, with 2% allocations in both October and November.

While the minority of Japanese pension funds that have set aside specific allocations to take advantage of shorter-term market opportunities might step in now to buy local equities, a greater number that remain overweight or were at target when the rally started could take the opportunity now to sell down to their policy allocation targets, noted Akihiko Ohwa, a part-time lecturer at Waseda University Graduate School of Finance, Accounting and Law, who stepped down in October as manager of Tokyo-based IBM Japan Ltd.'s pension fund.

Investment consultants likewise see little likelihood of renewed near-term interest in Japanese equities.

Meanwhile, even after reducing Japanese equity allocations over the past decade, most pensions remain overweight Japanese equities relative to global indexes, so it's tough to make the case that they should boost exposure even if Mr. Abe's administration enjoys some success in boosting economic growth, Mr. Ogai said.

Konosuke Kita,
Russell Investments' Tokyo-based director of consulting for Japan, agreed, saying signs that Mr. Abe's policies are enjoying some success could potentially slow but not reverse the move away from equities.

Foreign bond shift

The bigger issue facing pension executives now could be the risks of holding so many Japanese government bonds should government debt levels continue to rise and inflationary pressures develop, Mr. Kita said. Such a prospect should further support interest in alternatives to Japanese government bonds, including foreign bonds, infrastructure and hedge funds, he added.

Hideo Kondo, Tokyo-based asset management director for the $1.2 billion DIC Pension Fund, said Mr. Abe's policy goals have made positioning his fund to better deal with rising interest rates a central focus for him now.

After 20 years, Japanese investors, accustomed to a deflationary environment, may be slow to see the full implications of Mr. Abe's policies, but if the new government takes decisive action to make Japan's economy a “normal” one again, asset allocation changes could follow in short order, Mr. Kondo predicted.

Two milestones that could affect Mr. Abe's room to maneuver are coming in 2013: In April, a new Bank of Japan governor will be appointed. In July, an election is set for the upper house of Japan's parliament, still controlled by the Democratic Party of Japan which ran the government for the prior three years.

However, the yen's roughly 10% depreciation against the dollar since mid-November suggest some market players are paying attention to Mr. Abe's promise to open Japan's monetary spigots enough to produce a little inflation.

For now, Japanese pension executives reviewing asset allocation for the fiscal year starting April 1 seem more focused on further yen depreciation than on equities, noted Hiroshi Yokotani, product director-fixed income with Tokyo-based
AllianceBernstein (AB) Japan Ltd.

That's prompting several to consider shifting a small portion of Japanese government bonds exposure, which accounts for roughly 50% of a typical portfolio, to foreign bonds, with a number of discussions about “risk-barbelled” allocations to foreign government bonds rated double-A or higher at one end and higher risk spread products such as foreign high-yield bonds, bank loan strategies or emerging markets corporates at the other end, Mr. Yokotani said.

Okayama Metal & Machinery's portfolio is already further down that road, noted Mr. Kiguchi, having replaced its last holdings of Japanese government bonds three years ago with alternatives, including high yield bonds, bank loans, emerging market debt and long/short allocations to U.S. and Japanese credit. The pickup in investors looking to allocate to credit markets now has left his team taking a “contrarian” stance, trimming its credit-related investments, he said.

This article originally appeared in the January 7, 2013 print issue as, "Japanese funds not rushing to equity".